August 15, 2024 Josh Ryan-Collins – University College London   In the post-war period, central banks worked closely with other government agencies to steer credit towards priority industries and repress financial flows to undesirable sectors. These ‘credit guidance’ policies, which took a variety of institutional forms, were key to rapid industrialisation and structural economic change in many high income and middle-income countries. These regimes stand in contrast to the current risk-based, market-led paradigm favoured by central banks seeking to support decarbonisation and the climate transition via adjustments to financial regulation and monetary policy.  The current regime is less focused on the needed structural change – which will require discretionary market-shaping policies – and more on supporting markets to lead the transition whilst maintaining (short-term) financial stability. Two important and interrelated institutional barriers prevent a simple transference of twentieth credit guidance policy to modern day central banks. Firstly, central bank independence and with it a strict focus on inflation above and beyond other factors, coupled with a related need for market-neutrality and a limited role for expansionary fiscal policy; a regime of ‘monetary dominance’. Secondly, the existence of a large and globalised market-based financial system. This constrains more discretionary credit policy interventions for financial stability reasons whilst also providing an alternative source of financial flows to dirty sectors, weakening any new bank-based regulations.  In this essay, I discuss these two factors in more depth and consider how an ‘allocative green credit policy’ regime might deal with such challenges.[1] The risk-based regime and its flaws Central banks have focused on two main strategies in pursuing decarbonisation: first, enhancing price discovery (market-fixing) under a supervisory umbrella and, second, correcting price signals (derisking) under a monetary policy umbrella.  Both approaches emphasize risks to the financial sector (‘financial materiality) rather the damage the financial sector might do the environment and ultimately delegate the pace and direction of the green transition to the private sector. The market-fixing supervisory approach assumes that climate-related financial risks are measurable and quantifiable. By encouraging private financial firms to recognise, disclose and measure these risks, through interventions like climate scenario analysis and stress tests, more efficient price discovery can occur and the market can smoothly enable the transition. I have written extensively on one major weakness of this approach: such ‘risks’ cannot be accurately quantified given the fundamental uncertainty attached to them, as also noted in an earlier essay in this roundtable. A second, related issue is that this regime conveys epistemic authority to private actors who may have conflicts of interest. The most prominent risk disclosure frameworks (e.g., TCFD, 2017) have been developed almost exclusively by coalitions of multinational firms acting through non-profit entities. Similarly, ESG ratings providers are all private sector–led. Private sector–led methodologies are subject to perverse incentives to underestimate risks and avoid potential adverse consequences on cost of capital. The EU sustainable taxonomy, for example, Europe’s landmark legislation for standardising green definitions to enable market-fixing, has suffered from the ‘dilution effect’ of carbon lobbies, with legislation successfully amended in July 2022 to include fossil gas and nuclear energy as taxonomy-eligible sustainable economic activities. A third issue with the risk-based approach is its limited ability to address market-based financing of dirty activities.  The complex ecosystem of institutional capital has various obscure mechanisms to move carbon assets across opaque balance sheets to circumvent the changing relative price signals created by derisking interventions, or the disclosure requirements required by market-fixing policies. Indeed, such dynamics are now acknowledged to be at play in the oil and gas lending space across North America and Europe. For example, since 2021, private equity firms have acquired over $25bn of oil and gas assets from the public markets. Paradoxically, while regulated financial institutions may be ostensibly divesting from fossil assets, their indirect support for high carbon activities, including the exploitation of fossil fuels, continues via other more opaque channels. In particular, bank loans decreased by $97.1bn last year, even as fossil fuel bond issuance enjoyed a robust year, increasing by $24.3bn. Since 2019, banks have turned to so-called proved developed producing securitisation, in which an oil or gas producer issues bonds in an asset-backed securitization or repo- transaction, using the cash from oil and gas production as collateral for the notes placed with investors. Meanwhile, the great inflation of the post-covid 2021-2023 period has revealed the limits of central banks’ efforts to green monetary policy via the correcting of price signals.  Fully aware that raising rates across all sectors would hit capital-intensive renewables harder than fossil fuels, they went ahead anyway. ‘We are not, and will not be, a “climate policymaker”’, proclaimed Jerome Powell, the President of the US Federal Reserve in January 2023 after 18 months of inflation well above the Fed’s 2% target. Perhaps the most revealing example is the European Central Bank (ECB’s) implicit abandonment of its corporate asset purchase ‘tilting’ program, a sophisticated framework for redirecting credit flows from dirty to green corporate issuers. Tilting was the closest any modern-day Global North central bank had come to the credit guidance regimes of the post-war period. It involved closely monitoring and disciplining the climate performance of corporates, going a step beyond Global North central banks’ comfort zone of monitoring bank balance sheets for financial stability purposes. Political pressure eventually told. In early 2022, Conservative EU law-makers tabled several amendments to paragraphs relating to the ECB’s climate strategy, claiming it was a distraction from its duty to tame inflation. Meanwhile, prestigious scholars and other central bank governors agreed that there was a risk of ‘mission creep’ with the ECB’s current approach. Under considerable political and institutional pressure, the bank discontinued its tilting program after just 8 months as it switched from quantitative easing to quantitative tightening in the summer of 2023 but failed to apply any dirty or green criteria in determining which bonds it sold first. The bank also reneged on a commitment to green collateral requirements at the end of December 2022, citing a lack of empirical evidence. Allocative green credit policy Effectively steering finance requires not just authority to deploy particular policy instruments but also institutional configurations and mechanisms that coordinate the actions of central banks and financial authorities with other policy actors, including mechanisms to monitor progress, enforce non-compliance, and resist the influences of special interest groups. Historical uses of allocative credit policies give an indication of how such institutional forms took shape during the post-World War II period. Deployed in countries such as England, France, Italy, South Korea, and Japan to support rapid (re-)industrialisation, various credit guidance tools and institutions, including publicly owned industrial development banks, were used to promote credit growth in desirable sectors and restrict it for undesirable activities. One of the best-known examples is France. The French developed an institutional configuration that brought together the central bank, public banks, the Treasury, and other departments under a National Credit Council (Conseil National du Credit – CNC) as has been described by Eric Monnet, amongst others.  The CNC set and monitored the deployment of credit policies including rediscounting, quantitative limits on refinancing credit, reserve requirements coupled with liquid asset ratios (which required banks to hold a minimum ratio of medium-term credit relative to total assets), and credit ceilings (encadrement du crédit) to slow down bank lending in specific periods. The overall policy objective was to increase the creation of ‘investment credit,’ defined as medium- (two to five years) and long-term (more than five years) loans to non-financial firms, given political consensus that a shortage of this finance was impeding capital investment and productivity growth. Broader government policy goals,  including increasing export credit and supporting regional development, also informed the objective.  The regime was largely successful in achieving its broader policies (Loriaux et al., 1997; Monnet, 2018). Rediscounting in particular was successful in shifting the lending pattern of commercial banks. By the early 1970s commercial banks were contributing over 30% of investment credit, up from almost zero for the majority of the 1950s period. Overall, investment credit increased from 1% of GDP in 1949 to 25% by 1973 during a period when the French economy experienced its highest rates of output growth and capital accumulation (Monnet, 2018, p. 218). The French experience suggests two take-aways. First, the institutional arrangements needed under the French context, particularly those determining explicit coordination between fiscal and monetary authorities, have no equivalent in any major economies today. The French used quantitative controls to manage inflation rather than interest-rate hikes across all sectors, subordinating to   monetary policy to credit and industrial policy objectives; this was an institutional regime of fiscal rather than monetary dominance. Second, today’s globalised market-based financial system implicates a broader range of market actors than just regulated banking institutions, green credit policy therefore necessarily requires more policy intervention in such markets to address ‘backdoor’ credit creation that threatens to undermine decarbonisation trajectories. Quantity- as well as price-based tools will be needed to deal with the market-based finance that might otherwise substitute for bank lending. Quantity-based policies could include the mandatory exclusion of dirty assets from indexes marketed as ESG which would set the basis for an adequate regulation of dirty investments in passive funds.  A 100% haircut on securities issued by fossil fuel companies could limit the potential for ‘greenwashed’ credit allocation via private repo markets. With their balance sheets sitting at the heart of market-based credit creation, central banks are arguably a key public agency in governing such a disciplining effort.  They have already begun to play a more active role shaping the shadow banking infrastructure for financial stability and monetary policy purposes. A number of arguments have been put forward to explain why quantity-based allocative green credit policies may be more effective than the risk-based approach in shifting financial flows to support the green transition. Evidence and theory suggest that banks engage in quantity-based credit-rationing, meaning the market-determined interest rate cannot then be viewed as a reliable indicator of efficient credit allocation. Quantity-rationed markets are then not defined by a price equilibrium, but by quantity determination on the supply side (the bank in this case), whatever the interest rate.  This literature proposes there is hence a strong case for quantitative credit guidance policies rather than relying solely on price-based signalling.  Relatedly, capitalist firms are driven by the perception of future profits, rather than relative prices today. As Brett Christophers has illustrated, although the unit cost-price of renewable energy technologies like solar and wind have now reached parity or even become cheaper than fossil fuels, these industries remain significantly less profitable than the latter and hence continue to attract less investment. Furthermore, the evolutionary economics literature has argued that dynamic structural economic change requires proactive public policy interventions.  Changing price signals alone is seen as a blunt tool to stimulate green investment, because green innovation is subject to complex non-linear dynamics such as path dependency, network externalities, technological inertia, and ‘lock-in’ effects.  As I have argued previously, using policymaker discretion to steer finance is necessary given the wide uncertainty ranges of attempts to quantify and internalise unprecedented environmental ‘risks’ into market prices. Discussion No major central bank wishes to be seen as a ‘climate policymaker.’ Yet, at the current juncture, a ‘climate policymaking’ central bank may be precisely what is required to overcome the limitations of the risk-based, market-led approach in supporting the rapid realignment of financial flows required for the success of a green transition. We must ask what institutional and political barriers may yet impede the materialisation of such a policy regime to support decarbonisation. First, new institutional forms would be needed to facilitate and legitimise deliberative coordination between central banks and other public agencies implicated in credit policy.  Using credit allocation policies to accelerate the growth and diffusion of new innovation-intensive industries whilst concurrently managing the decline of legacy sectors has no obvious historical precedent and may pose macro-financial stability risks in certain sectors. This trade-off could be managed by deploying credit policy in careful coordination (e.g., on an ‘escalating’ basis) with a broader suite of industrial policy measures designed to mitigate the economic dislocations associated with transitioning sectors. This implies far more institutional coordination between financial and fiscal/industrial policy than is currently deemed appropriate. Relatedly, dislocations in legacy sectors may have inflationary consequences if new green sectors are not readily able to absorb excess labour and capital – dynamics that are already playing out in energy markets, albeit under mainly geopolitical rather than transition-related circumstances. Central banks may have to tolerate short- or even medium-term periods of inflation to enable the green transition, calling into question the current inflation-targeting regime. More broadly, targeting quantities of credit through policy is arguably already incompatible with economy-wide inflation-targeting, given the argument that price should be market-determined. One solution is to disaggregate measures of inflation and in other ways further refine central banks’ inflation targets and policy tools. Further research is needed to address these questions. Operationalising an allocative credit policy framework would also require several enabling policy reforms. First needed is a public taxonomy that determines harmful activities that are incompatible with government transition objectives, where capital allocation must be urgently restricted. Also necessary are mandatory disclosures – for both regulated lending institutions and broader institutional capital – of portfolio composition to priority and dirty activities, together with mandatory phase-out plans for the latter, where relevant. Finally, to ensure the effective design and coordination of green credit policy, new national public agencies comprised of representatives from central banks and relevant financial supervisory bodies and ministries of finance, industry and environment/climate may be needed to monitor its ongoing effectiveness in supporting green industrial strategy. In other words, a return to the French-style national credit council model; Eric Monnet has proposed how it might work in the Eurozone context. Of course, forms of state coordination are themselves not immune to the influence of special interests, particularly as credit allocation policies will also certainly result in distributive consequences. Future scholarship on the international political economy of finance should seek to further develop these questions and better understand the coalitions that made possible to the relatively effective credit guidance regimes of the post-war period. What is clear is that the current macrofinancial regime may be reaching its political and ecological limits, but alternatives are yet to take root. [1] A more extensive version of the arguments presented here can be found in this working paper co-authored with Katie Kedward and Daniela Gabor. A more recent version is also forthcoming in the Review of International Political Economy, entitled “Carrots with(out) sticks: Credit policy and the limits of green central banking”.